How Today's FOMC Statement Differs from the August 9 Statement?

The Federal Open Market Committee decided today to raise its target for
the federal funds rate by 25 basis points to 3- 3/4 percent.

The Committee believes that, even after this action,
the stance of monetary policy remains accommodative and, coupled with
robust underlying growth in productivity, is providing ongoing support
to economic activity. Aggregate spending, despite high energy prices,
appears to have strengthened since late winter, and labor market conditions
continue to improve gradually. Core Output appeared
poised to continue growing at a good pace before the tragic toll of Hurricane
Katrina. The widespread devastation in the Gulf region, the associated
dislocation of economic activity, and the boost to energy prices imply
that spending, production, and employment will be set back in the near
term. In addition to elevating premiums for some energy products, the
disruption to the production and refining infrastructure may add to energy
price volatility.

While these unfortunate developments have increased
uncertainty about near-term economic performance, it is the Committee's
view that they do not pose a more persistent threat. Rather, monetary
policy accommodation, coupled with robust underlying growth in productivity,
is providing ongoing support to economic activity. Higher energy and
other costs have the potential to add to inflation pressures. However,
core inflation has been relatively low in recent months and
longer-term inflation expectations remain well contained, but
pressures on inflation have stayed elevated.

The Committee perceives that, with appropriate monetary policy action,
the upside and downside risks to the attainment of both sustainable growth
and price stability should be kept roughly equal. With underlying inflation
expected to be contained, the Committee believes that policy accommodation
can be removed at a pace that is likely to be measured. Nonetheless, the
Committee will respond to changes in economic prospects as needed to fulfill
its obligation to maintain price stability.

In its 11th interest rate hike of the present tightening cycle,
the Federal Open Market Committee stuck with the script of the last 15 months,
of gradual interest rate hikes and a balanced economic assessment. The Fed's
decision to raise rates in the face of its acknowledgement of the "associated
dislocation of economic activity, and the boost to energy prices imply" of
Hurricane Katrina implies that the central bank deem these as mostly transitionary.

Fed Action & Words: 20 months elapsed and little
change

FOMC Meeting

Balance of Econ Risks

Balance of Price Risks

Policy Accommodation

Labor Mkts. Reference

5/6/2003

Roughly Equal

Negative

None

None

6/25/2003

Roughly Equal

Negative

None

None

8/12/2003

Roughly Equal

Negative

Considerable Period

Mixed

9/16/2003

Roughly Equal

Negative

Considerable Period

Weakening

10/28/2003

Roughly Equal

Negative

Considerable Period

Stabilizing

12/9/2003

Roughly Equal

Almost Equal

Considerable Period

Improving modestly

1/28/2004

Roughly Equal

Almost Equal

Patient in removing it

Improvement

3/16/2004

Roughly Equal

Almost Equal

Patient in removing it

New hiring lagged

5/4/2004

Roughly Equal

LT Inflation Contained

Removed Measurably

Hiring Picked up

6/30/2004

Roughly Equal

Roughly Equal

Removed Measurably

Improved

8/10/2004

Roughly Equal

Roughly Equal

Removed Measurably

Improvmt. slowed

9/21/2004

Roughly Equal

Roughly Equal

Removed Measurably

Modst. improvmt.

11/10/2004

Roughly Equal

Roughly Equal

Removed Measurably

Improved

12/14/2004

Roughly Equal

Roughly Equal

Removed Measurably

Improved gradually

2/2/2005

Roughly Equal

Roughly Equal

Removed Measurably

Improved gradually

3/22/2005

Roughly Equal

Roughly Equal *

Removed Measurably

Improved gradually

5/3/2005

Roughly Equal

Roughly Equal *

Removed Measurably

Improved gradually

6/30/05

Roughly Equal

Roughly Equal*

Removed Measurably

Improved gradually

8/10/2005

Roughly Equal

Roughly Equal *

Removed Measurably

Improved gradually

9/20/2005

Roughly Equal

Roughly Equal *

Removed Measurably

Improved gradually

The fact that the Fed deems "core inflation has been relatively low in recent
months and longer-term inflation expectations remain contained" despite the
surging volatility in energy prices, means the central bank is highly confident
of the accommodative role of its overall monetary policy.

Indeed, despite the 11 rate hikes of the past 15 months, liquidity remains
plentiful. The red graph in the chart below shows that the month-to-month
increase in money supply (M2) has fallen over the past few years. This year's
average monthly growth of M2 liquidity stands at 0.2%, well below the 0.5%,
0.4% and 0.5% in 2004, 2003 and 2002. This clearly suggests that Fed's tightening
campaign is aimed at normalizing interest rates towards a neutral level -
most likely at a 4.00%-4.25% fed funds target, but without hindering economic
growth, hence, maintaining an "accommodative" policy via generous M2 liquidity.

Moreover, our rationale for a pause in monetary policy is underlined by the
emerging of a slowing US consumer in the 2 years preceding the Hurricane.
The next chart shows that the contribution of US consumers and companies into
GDP growth to have slowed invariably. The slowdown in consumers' contribution
to GDP from 4.1% in Q3 2003 to 2.1% in Q2 2005 occurred well before the 30%
increase in gasoline prices between July and mid September. Falling consumer
confidence (tumbling Univ of Michigan), increased jobless claims and unemployment
which are not guaranteed to be filled are factors that are cause for a Fed
pause. It may be argued that a Fed pause today might have run the risk
of bringing the Fed it behind inflation especially that there is no scheduled
meeting in October. But as we argued over the past year, the contractionary
risks of higher oil are increasingly shadowing the inflationary risks of oil.
And the aforementioned spillover effects of Katrina are likely to be distributed
over the next few months, especially when the economy has been stretched thin
by the factors seen in the chart below.

FX Impact

The Fed's ruling that the hurricane impact did "not pose a more persistent
threat" 3 weeks after the hurricane implies that the central bank shall continue
to deliver its measured tightening policy into year's end. This would normally
be a dollar positive as it expands the currency's yield superiority relative
to the Eurozone, Canada, Japan and Switzerland while narrowing the yield disadvantage
relative to Australia and the UK. But we should remind readers the dollar began
selling-off in the first week of July - about 2 weeks after Fed Chairman's
positive testimony signaled a continuous tightening in each of the year's remaining
scheduled meetings.

Nevertheless, this time the dollar could get a deja-vu of May 2005 - when
uncertainty in the EU Constitution coupled with continued Fed tightening produced
a convincing dollar rally. As long as the deadlock in German elections remains,
there exists the potential for the dollar to break below the $1.21 figure and
test the $1.2030 target into the figure by end month. A compromise between
Chancellor Schroeder and CDU leader Angela Merkel would be more helpful for
the Euro than a "repeat" of the elections--in which case political disarray
should lead to the break of the $1.20 and onto $1.1960.

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